Our Perspective on the Government Shutdown and its Consequences

As you have undoubtedly heard by now, a U.S. government shutdown started on October 1st.

The question for an increasingly skeptical investing public is: how will this affect the U.S. economy and (without sounding too self-centered) our retirement portfolio?

The political debate centers around raising the U.S. debt ceiling and the possibility of a government default on its debt obligations as soon as October 17th. Interestingly, it is starting to look like the government shutdown, if it runs for weeks instead of months, might have almost no effect on the economy at all. Why? The economic impact that had economists worried was the loss of income suffered by tens of thousands of federal employees. But the Defense Department has continued paying most of its civilian personnel, simply by declaring all of them "essential employees." Not only were the leaders of the House of Representatives not inclined to argue; they have quietly passed legislation that would give back-pay to all federal workers who have been furloughed, just as soon as the stalemate ends. It is expected that the Senate and the President are likely to sign this bill.

One may expect some kind of a stock market sell-off before the shutdown ends. For the Republican leaders in the House, there is little cost to holding their ground so long as there is not a public outcry and loss of voter confidence. Indeed, if you listen closely to the speeches by President Obama and the Democratic leadership, you hear dire warnings that the market will drop as a result of the shutdown--which some say is their way of focusing the public's attention on the other party. The last time the government was shut down, stocks dropped 20%, the Republican leadership realized it wasn't winning any popularity contests, and the stalemate ended.

A more consequential issue is the debt ceiling. Congress must raise the total amount that the U.S. government can borrow (by selling Treasury bonds) to pay its various obligations, including, of course, interest on its current Treasury bonds. Contrary to popular belief, raising the debt ceiling does not increase the federal debt; that debt exists whether or not Congress authorizes additional borrowing.

Failure to authorize the government to pay its legal obligations would create a self-induced fiscal crisis--and it could lead the nation to voluntarily default on the its debt obligations, which even Greece has thus far avoided.

One recent article suggested that a default on Treasuries would ripple through the global economy, among other things, causing anxious investors to demand higher interest rates and dramatically raise U.S. borrowing costs. That, in turn, would raise rates on mortgages, credit cards and student loans, pushing the U.S. toward or into recession and putting pressure on the stock market. One report suggests that if the U.S. misses just one interest payment, the downward impact on stock prices could be greater than the Lehman Brothers bankruptcy, where the stock market lost half its value.

Bigger picture - a default would undermine the role of the U.S. in the world economy.

As it happens, the gap between government spending and tax revenues has fortunately been decreasing rapidly on its own. In July, the Congressional Budget Office reported that the deficit had fallen by 37.6%, the result of tax increases and sequester-related cuts in spending. As a percentage of America's GDP, the deficit has fallen from more than 10% at the end of 2009 to somewhere around 4% currently. Last June, the government posted a surplus of $117 billion, paying down the overall deficit.

Most observers seem to think that all of this will get worked out. The stock market's current normal trading indicates that investors expect a compromise on the government shutdown. It may take a sharp day of selling to motivate Congress. Foreign investors are still lending to the U.S. government at astonishingly low interest rates (despite modest increases over the past week).

The last time we went through this, the stock market plunge proved to be a buying opportunity for investors. Uncertainty and volatility often create anxiety and opportunity that only disciplined investors are able to benefit from. We continue to adhere to a consistent and time-tested strategy of re-balancing our performing asset classes into those that have lagged, which facilitates a buying low and selling high approach.